Chapter 8
Why Do Financial Crises Occur and Why Are
They So Damaging to the Economy?
What is a Financial Crisis
Agency Theory and the Definition of a Financial Crisis
Dynamics of Financial Crises in Advanced Economies
Stage One: Initiation of Financial Crisis
Stage Two: Banking Crisis
Stage Three: Debt Deflaton
Case: The Mother of All Financial Crises: The Great Depression
Stock Market Crash
Bank Panics
Continuing Decline in Stock Prices
Debt Deflation
International Dimensions
Case: The Global Financial Crisis of 2007–2009
Causes of the 2007–2009 Financial Crisis
Effects of the 2007–2009 Financial Crisis
Mini-Case: Collateralized Debt Obligations (CDOs)
Residential Housing Prices: Boom or Bust
Inside the Fed Box: Was the Fed to Blame for the Housing Price Bubble?
Global Box: The European Sovereign Debt Crisis
Height of the 2007-2009 Financial Crisis
◼ Overview and Teaching Tips
Financial crises are inherently interesting because they are so dramatic. This has become even more true
with the global financial crisis of 2007–2009, which Alan Greenspan characterized as a once-in-a-century
credit tsunami. Indeed, teaching this chapter on financial crises has stimulated student interest more than
anything else I have taught in my entire career of over thirty years of teaching.
This chapter is an application of the agency theory, the economic analysis of the effects of asymmetric
information (adverse selection and moral hazard), that was covered in the previous chapter. Agency theory
is used to outline the six factors that play key roles in financial crises. Your students will really start to get
engaged when you outline the dynamics of financial crises through its multiple stages. I have found that
Figure1.1 with its schematics is especially helpful in getting the dynamics across in class.
40 Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition
Students will be most interested in using the analysis to discuss the recent 2007-2009 financial crisis,
which is the worst financial crisis to hit the world since the Great Depression. Nonetheless, the case
discussing the Great Depression is worth covering because it contains so many lessons for today. Taking
students through the data in the figures and telling the war stories of what happened during these crisis will
make the discussion real world and also drive home the theory of financial crises developed in the chapter.
◼ Answers to End-of-Chapter Questions
1. Asymmetric information problems (adverse selection and moral hazard) are always present in
financial transactions but normally do not prevent the financial system from efficiently channeling
2. When an asset-price bubble bursts and asset prices realign with fundamental economic values, the
resulting decline in net worth means that businesses have less skin in the game and so have incentives
3. An unanticipated decline in the price level leads to firms real burden of indebtedness increasing while
there is no increase in the real value of their assets. The resulting decline in a firm’s net worth
4. A decline in real estate prices lowers the net worth of households or firms that are holding real estate
assets. The resulting decline in net worth means that businesses or businesses have less at risk and so
5. If financial institutions suffer a deterioration in their balance sheets and they have a substantial
contraction in their capital. They will have fewer resources to lend, and lending will decline. The
6. A failure of a major financial institution which leads to a dramatic increase in uncertainty in financial
7. Credit spreads measure the difference between interest rates on corporate bonds and Treasury bonds
of similar maturity that have no default risk. The rise of credit spreads during a financial crisis (as
Chapter 8: Why Do Financial Crises Occur and Why Are They So Damaging to the Economy? 41
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occurred during the Great Depression and again during 2007–2009) reflects the escalation of
asymmetric information problems that make it harder to judge the riskiness of corporate borrowers
and weaken the ability of financial markets to channel funds to borrowers with productive investment
opportunities.
8. Bank panics occur because of asymmetric information which results in depositoors being unable to
tell whether their bank is a good bank or might be insolvent when the financial system is subject to a
9. With fewer banks operating, information about the creditworthiness of borrowers will shrink, so that
there will be more severe moral hazard and adverse selection problems.
10. With restrictions lifted or new financial products, financial institutions often go on a lending spree
and expand their lending at a rapid pace. Unfortunately, the managers of these financial institutions
may not have the expertise to manage risk appropriately in these new lines of business, leading to
12. Both the Great Depression and the 2007-2009 crisis were preceded by sharp increases in
asset prices. During the two episodes, credit spreads widened, the availability of credit shrank, and
economic activity sharply declined. The two episodes differ in the source of asset price increases:
during the Great Depression, rising stock prices were the trigger, whereas in the recent crisis a
13. The use of data mining to give households numerical credit scores which can be used to predict defaults
14. Because the agent for the investor, the mortgage originator, has little incentive to make sure that the
